As the year comes to an end, it is time to start looking at your deductions, and whether you will be taking the standard deduction or itemizing. When taking the standard deduction, the IRS has set dollar amounts—based on filing status—to subtract from your income. You also have the option to itemize which allows you to subtract expenses deemed eligible by the IRS. The best choice is the larger of the two options.

When the Tax Cuts and Jobs Act was passed in 2017, one of the big changes was the near doubling of the standard deduction. The result is that the standard deduction became a better option for many taxpayers. Although it may be easier to take the standard deduction, it is never a bad idea see if itemizing will yield a larger benefit.

What Can Be Itemized?

Charity

You can deduct charitable gifting whether it be cash or noncash contributions. With noncash charitable deductions, you can deduct up to the fair market value of the items. If you do not have a good sense of what the value of the items donated may be, keep receipts or documentation of the gifting, and consult your tax preparer.

Mortgage Interest

Your mortgage company will provide you with a Form 1098 that breaks down which part of your payments went towards mortgage interest. You can also deduct interest on a second mortgage or home equity line of credit (HELOC) with a few conditions. For a second mortgage and HELOC, the expense must go toward either current home renovations or the purchase of an additional property. Both primary and secondary mortgage interest deductions are limited to balances of $750,000 if the debt was incurred after December 15th, 2017. If the debt was incurred prior to December 15th, 2017, then you can deduct interest on up to $1,000,000 of the balance.

Medical Expenses

Medical expenses can be deducted if they meet certain guidelines. Your medical expenses must exceed 7.5% of your adjusted gross income (Form 1040, Line 8b) to be deductible. Only the expenses that exceed 7.5% will be deductible. Expenses that qualify to be itemized are health insurance premiums, long term care premiums, prescription drugs, etc.

Other Taxes

Taxes you have paid during the year can also be used as an itemized deduction. Such taxes include state, local, real estate, and personal property taxes. A $10,000 cap on deducting taxes was imposed with the 2017 Tax Cuts and Jobs Act.

Case Study

John and Jane Dough are a retired couple deciding if they should itemize or take the standard deduction for 2020.

Their mortgage was refinanced in 2020 for $1,000,000 at a 3% interest rate. The first year, they are going to pay roughly $30,000 in interest. However, they are only going to be able to deduct interest on $750,000 of their mortgage because the debt came after December 15th, 2017, which comes to $22,500.

Next, we will look at their medical expenses. John and Jane pay healthcare premiums of $12,000 annually and had $4,000 of additional qualified medical expenses for 2020. Their income before deductions for 2020 is $175,000. Using the 7.5% rule, they can deduct medical expenses above $20,625 ($175,000 x 7.5%). The Doughs will not be able to deduct any of their medical expenses since $16,000 does not exceed the $20,625 threshold.

The Doughs have roughly $4,000 in state income tax as well as $10,000 in property tax. Though they have paid $14,000 in local taxes, they will only be able to deduct a maximum of $10,000.

Lastly, the Doughs donated some clothing to their local Salvation Army as well as $5,000 in cash to their favorite charity. The goods donated cost the Doughs $1,500 but had a fair market value of $500 when donated. The Doughs will be able to deduct the $5,000 cash donation as well as the $500 value of the donated goods.

The Doughs have a total of $38,000 of itemized deductions which is greater than the $24,800 standard deduction for joint filers. They will do well to keep track of deductions and provide this information to their tax preparer.

Does Itemizing Make Sense for You?

If you have itemized your deductions in the years since 2018 and have similar expenses, then it makes sense to continue to keep track of your qualified expenses. If your itemized deductions have not exceeded the standard deduction and nothing has changed, it’s like you won’t qualify again this year.  If you are close, it may pay to look into a “bunching” strategy that could help you itemize every other year.  See “New Tax Strategies” that we wrote a couple years ago when the tax laws changed significantly.